Fixed Income Insights: Fiscal Stimulus Drives the "Reflation Trade"

Rich Consul: Welcome to the INCORE Capital Management Fixed Income Insights for the first quarter of 2021. My name is Richard Consul. I'm a senior portfolio manager with the INCORE Capital team. Title of our presentation today is Fiscal Stimulus Drives the Reflation Trade. From an overview perspective, our thoughts can be broken down into four areas. Our macro view, monetary and fiscal policy view, corporate credit, and finally, positioning commentary. From a macro perspective, we see the economy continuing to rebound in 2021, but it's important to know that the percentage loss in economic activity experienced in 2020 was actually larger than the realized economic loss experienced during the 2008-2009 recession. However, it's really the coordination of fiscal and monetary policy, what we refer to as MMP, which is likely to propel 2021 growth to its highest levels since the early 1980s. This robust economic growth is really based on expectations from readings that we've recently seen from ISM and elevated consumer savings rates, which we'll discuss in the pages ahead.

Despite this overwhelming stimulus and kind of the growing vaccine distribution, one area of concern for us is that the labor market improvement has slowed. And we'll discuss that in greater detail. From a monetary perspective, what's really going on is this coordination between the Federal Reserve and the US Treasury Department, where the US Treasury and the government basically supports 5.4 trillion in fiscal stimulus that has already been signed into law since April 2020, while also possibly passing another $2 trillion infrastructure plan. And the coordination effect is where the Federal Reserve comes in and monetizes debt issuance or offsets and purchases the Treasury's issuance. And it really basically is a way of kind of printing money to allow for short-term economic expansion.

The concern that we have is really governments are ineffective allocators of capital, and this wanton spending typically fails to support long-term economic productivity growth. We are concerned that while this coordinated activity of government spending and monetary policy is likely to be stimulative in the short term, we're very concerned about kind of the longterm effects, especially as the Fed balance sheet continues to grow at a pace of $120 billion per month. From a corporate credit perspective, corporate fundamentals are beginning to improve following the economic slowdown, and spreads have returned back to pre-COVID levels as the financial balance sheet and overwhelming fiscal stimulus has really propelled corporate balance sheet repair back into high gear.

However, the first quarter of 2021 really saw the largest quarter of activity as it relates to M&A activity in us history. And that is a concern. We're just basically seeing a lot of companies just kind of merge, which could be a potential deteriorator in the quarters ahead of corporate credit. However, fiscal and monetary policy combined with a reopening economy is likely to continue to drive credit spreads to record heights in the quarters ahead. From a positioning perspective, we are overweight high quality issuers in both investment-grade high-yield and investment-grade convertibles. However, we are recommending that investors trade rates tactically with a bias to short duration in the long end of the curve.

From a macro perspective, we present our GDP overview slide here. And we've broken down GDP growth from a year over year perspective, going back to 2007. And what we can see are the four different main contributing factors to GDP, and then the overall kind of real GDP score in dark blue there. And what you'll notice is that 2020, the US economy contracted by 3.5%. This is more than the 2008-2009 recession. But while it took five years to recover from the 2008-2009 recession from an economic activity perspective, we are likely to recover from the 2020 contraction by the end of this year, as median expectations are for a robust 6.2% GDP growth for this year. Important to note is that would be the fastest economic growth rate for the United States since 1984. It's been a while since we've seen growth rates this high. And a lot of this raised economic expectation is going to be based on the two slides that we're going to discuss now.

The first one here is ISM services in manufacturing PMI readings. You can see that we've brought this slide back to 2018, and both ISM manufacturing and ISM services are at all-time highs as far as this graph is concerned. However, when we break it down from a historic perspective, manufacturing PMI readings are the highest they've been since 1983. The services index reading of 63.7 is actually the highest in series history. So what we're seeing is that these surveys of expectations from corporate purchasing managers is very, very high. And usually this activity tends to support short-term economic growth expectations.

And some of this economic growth expectations really gets down to what is the consumer going to do? And a lot of what we've seen in the past nine months as it relates to the consumer consumption activity is a lot of that consumer consumption activity is based actually on the stimulus that they've received, whether it be from the fiscal stimulus checks or paycheck protection where they weren't laid off from their job and got enhanced payroll protections through their corporation, but given to them from the fiscal stimulus programs themselves. All of these help to contribute to really elevated savings rates and elevated income rates for the past nine months. And we can see it very clearly here as it relates to US savings rates.

When the first stimulus checks went out in April of last year, savings rates for US individuals spiked up to 33%, which was the highest level that we've ever seen in history. And we can see in the most recent spike up, in the December 2000 period of time, is the most recent fiscal stimulus check that was sent out, the $600 check that was approved in December and then distributed in early January. We can see that helping to elevate consumer savings rates up to 20%. The key point is, is that a lot of this fiscal stimulus that continues to get into the consumers' pockets really finds itself back into the economy in the form of higher consumer consumption rates. So while consumer savings rates remain above 12%, a lot of this is being driven by the fiscal stimulus that Congress is approving.

And another thing to note is that this money that the consumer is getting, isn't just going to food and sustaining kind of a budget. In some cases, you've got people who are receiving this, who are fully gainfully employed, and this is just literally extra money that they're using to basically go and consume more goods in the economy. Those two factors, between ISM and this elevated savings rates, are really the things that we think are going to drive US economic activity in the quarters ahead. However, one of the areas that is a concern is really what's going on in the employment area.

Now, since April of last year, we've gained 13 million of the 21 million jobs that we lost during the COVID crisis. A lot of those jobs have been brought back in a lot of different areas, construction, manufacturing, professional services. But one area that continues to lag is the leisure and hospitality area. And think about what the leisure and hospitality area is. That's your airlines, your restaurants, your hotels, your service industries, the areas that basically were most impacted when consumer consumption and consumer activity really went on pause during the COVID restrictions forcing lockdowns. Some of these jobs are not coming back. And the question that we are struggling with now is the slow gain that we've seen over the past couple months here. Is that slowing down a realization of the fact that there has been structural job loss in those jobs, especially in the leisure and hospitality area, aren't likely to come back anytime soon? So the 70 million jobs that were still kind of under-employed from the COVID crisis, are they likely to persist for some meaningful period of time?

And some of that is kind of reconfirmed on this slide, which looks at unemployment claims going back to 2019. We can obviously see where the spike in April 2020 occurred as far as layoffs. But one of the things I really want you to see is the US continuing claims, the orange line there, while it's improving, the speed of the improvement or the velocity of the improvement is obviously slowing. It gets back to what we just discussed in that previous slide is a lot of the job gain that we've seen, a lot of the easy jobs that were brought back online as we initially opened, we have now kind of reached a point in time where the job gain growth has definitely slowed and we're concerned about some of that structural job loss. Some of the structural job loss will be shown right here in this continuing claims slide. And it's something that we really advise investors to note, especially as we start to get to the third and fourth quarter of this year and some of that fiscal stimulus in elevated savings rates starts to dissipate as a driver for consumer consumption.

As we shift from kind of the macro economic thoughts to monetary and fiscal policy, we're looking at, on this slide, at CBO estimates, Congressional Budget Office estimate of debt to GDP levels. We've already spent 15.4 trillion, which Congress has passed since April of 2020. However, the administration design is to get additional 1.9 or $2 trillion in infrastructure spending. Much of this stimulus has only provided kind of a one-time effect. The key is really going to be, is any of it long-term productive to economic growth, i.e., does it make us more efficient as an economy, as a result, allow us to grow faster?

One of the things that we know from a lot of the economic research and academic research is once debt to GDP levels get over a hundred percent, that the debt burden imposed on the country typically slows down the economic growth in the years ahead. Why that's important is as we look to where we are right now in 2020, we are at a hundred percent debt to GDP levels. And with the expectation of continuing a lot of the stimulus spending and a lot of the deficit spending, our projected debt to GDP levels are going to continue to worsen as we proceed to the 2040 period of time. And we can see this as we break down the contributors to government spending when we look at CBO estimates for the different contributors, Social Security, discretionary spending, major healthcare programs, mandatory spending, and the area that really is expected to kind of impact the budget the most in the out years, which is net interest, right?

When you take on more deficit spending, when you spend more than you bring in from a tax perspective, what ends up happening is you add to the debt. When you add that debt, as we all know, that debt comes with interest. And that orange line there on the chart that kind of starts to flat line in 2026 and then starts to really take off in those out years is really kind of an expression of that concern.

As you add more debt through deficit spending, the net interest on those debt payments basically starts taking over your government spending as a whole. And that's really what is going to drive further budget deficit in those out years. And that's why one of the reasons that we're really concerned about this MMT is, yeah, it's great in the short term, it kind of gets us over the COVID hump and hopefully maintains as many businesses intact as possible during this COVID halt. But what it really kind of does is makes it vitally important that in those out years, that we find a way to really balance this budget. Because deficit spending in perpetuity without productivity gain is really just a recipe for economic disaster.

As we look at some of this spending, this spending really by the US government can not be done unless the Federal Reserve helps them out and assists. And they do that by basically their quantitative easing programs. You'll see on this chart, we look at quantitative easing 1, quantitative easing 2, and quantitative using 3, and basically, the last program. What I think everyone needs to take out of this slide is that quantitative easing 4 has added $3.6 trillion to the Federal Reserve's balance sheets since February 2020. And by the time they are done with quantitative easing 4, the Federal Reserve will have literally doubled the size of its balance sheets that it took on over quantitative easing 1, 2, and 3 combined.

This is an incredible expansion of the Federal Reserve's balance sheets, and really something that is of great concern to us, because you can't really just monetize debt artificially like the Federal Reserve seems to believe that you can. So as we kind of flip to now the credit perspective, as we mentioned before, credit spreads are back down to pre-COVID lows. The spike up that we saw in the chart here on an area called pandemic or labeled to the right there called pandemic, is that you'll notice that the March 2020 sell-off was dramatic, but very short-lived due to a quick FOMC response. The Fed's decision to do outright purchases of corporate bonds and corporate bond ETFs really helped spread levels rebound artificially fast, really, before the credit fundamental improvement that's only now just starting to take hold.

But spreads have returned to pre-crisis levels as excess liquidity kind of searches for yield. It's the only place to really get yield right now with overnight money market rates earning you basically near nothing, and 10-year treasuries still below 2%. There's really no yield to be found outside of taking on some corporate risk. And that's really helped to propel corporate spread levels back to pre-pandemic levels. But as we mentioned, some corporate metrics are starting to improve. You'll see on the slide, on the left hand side, we've got high yield default rates. High yield default rates are back to long-term 10-year trends of 2% averages. That's very good, but you can see they obviously spike up in 2020 where it got above six. We've been able to get right back to kind of a normalized level very, very quickly after the large default levels that we saw in 2020.

But on the leverage chart on the right-hand side, you'll see that corporates have really de-leveraged since the worst of the COVID crisis. And while they're not back to the pre-crisis leverage levels, they have improved significantly. And pretty much every call that you hear with management, one of their key goals for 2021 and '22 is to continue to de-lever the balance sheet. So we continue to expect some de-leveraging activity and credit improvement to continue in the quarters ahead.

From a summary perspective, our thoughts can really be boiled down to these four points. We believe the economy is going to continue to rebound in 2021. A lot of this rebound is basically going to be based on fiscal and monetary policy, continuing to provide stimulus. That stimulus is likely to drive financial asset prices higher as MMT is really implemented, and the economy continues to reopen as vaccines get further distribution. As a result of positive economic expectations and improving overall credit fundamentals, we believe in overweight to high-quality issuers in both investment grade and high yield bonds, as well as investment grade convertibles is warranted and advisable for fixed income portfolios. And then we continue to trade rates tactically with a bias or a lean to short duration in the long end of the curve, as we believe interest rates continue to, to normalize to pre-COVID levels. Thank you for joining us. My name is Richard Consul, and if you have any questions or concerns, please feel free to reach out to your Victory Capital client representative.